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Worldwide Crisis in the Welfare State: What next in the Context of Globalization? Address by Michel Camdessus

October 15, 1998

98/23

As prepared for delivery(Delivered in French)

Address by Michel Camdessus
Managing Director of the International Monetary Fund
at a seminar organized by Observatoire Chrétien des Réalités Economiques
Paris, France, October 15, 1998

The twentieth century has seen countless achievements and changes. As historians look back on this period, two developments are likely to stand out as being among the most definitive of our time. One, deepening as the century progressed, was the acceptance by many, indeed most, nation states of an obligation toward their citizens to provide a certain minimum level of well-being. In industrial economies, especially in Europe, this has led to the emergence of the welfare state. The other development has been rather more recent, especially in the last two decades of this century. It is globalization. Building on hard-won gains in trade liberalization, and aided by technological advances, a rapidly increasing volume of economic transactions now transcend national borders. In particular, it has spread into international financial transactions and capital flows, becoming the most prominent feature of the past decade.

Yet as we approach the end of the century, we find that both the welfare state and globalization face crises of sorts. The more immediate and visible relates to globalization, whose benefits to countries around the world have been undermined by widespread loss of confidence in financial markets, and consequently crisis threatens a number of economies. However, I am confident that this crisis is a temporary setback. There is enormous potential energy waiting to be harnessed if the international community takes the steps that are necessary. I have spoken at length on this topic elsewhere and will not dwell on it today.

The other crisis is less dramatic, less visible, but in the long-term scheme of things is more profound, more difficult to address. Welfare systems, based on the best possible motivation of ameliorating hardship and improving human welfare, have come to represent an enormous drain on the resources and the efficiency of many of the so-called welfare states.

I.The benefits from welfare states

Before turning to the crisis in the welfare state, let us reflect on what we mean by it and briefly on a historical perspective background to the growth of the welfare state.

The term "welfare state" has typically been applied to countries in which public spending has risen to very high levels in order to finance social programs. How high? There is no hard and fast rule, but the countries that are considered as being welfare states normally have governments whose expenditure is about half of their GDP: indeed in some countries, it has risen as high as 60 percent of GDP.

How did such spending levels come about? For most of this century, public spending increased because governments, and especially European governments progressively moved into activities that in the past had been left to the private sector. This trend was promoted by the interaction of particular events—world wars, depressions—with views or ethical systems that assumed that more government intervention would lead to higher social welfare. The main areas were:

the financing of education at all levels while at the same time tightening requirements for compulsory school attendance;

the financing of health expenditure for an increasing share of the population;

the provision of comprehensive pensions for most individuals;

various forms of social support to certain "disadvantaged" categories of individuals;

substantial compensation for the unemployed;

general and specific subsidies to particular products and activities; and

minimum social benefits.

The extraordinary growth in public spending that accompanied the creation of the welfare state can be appreciated by the change in the share of public spending in national income which took place between the beginning and the end of this century. At the beginning of this century, the public spending of the countries now classified as welfare states was only around 10–15 percent of their national incomes. Now as I have mentioned, in many countries, it is around 50 percent or more.

Was this a good development? Unquestionably social welfare has improved. The growth of public spending has reduced many risks and costs for the members of thesesocieties: the costs of being ill, illiterate, old, poor, or unemployed. Public welfare has taken great strides in terms of increased literacy and education levels; reduced infant mortality and longer life expectancy; and reduced trauma and despair that comes with unemployment or incapacitation. Who would wish now to turn the clock back?

II. The costs of the welfare state

Inevitably, there is another side to the provisions of the welfare state—the costs. As economists are fond of saying, there is no such thing as a free lunch. What is the negative counterpart of the benefits mentioned above? Two types of cost may be identified. One is the direct financial or budgetary costs of providing services. The other, perhaps more controversial, and certainly more difficult to measure, is the loss of economic efficiency that is associated with some types of social services, which reduce, for instance, incentives for seeking employment.

First, with respect to budgetary costs, the money needed to finance a welfare state must be raised mostly through taxation and, to a lesser extent, through borrowing.

The tax burdens (i.e., the share of taxes in national income) have increased enormously throughout this century reaching levels of around 45 percent of GDP in France and in Italy and even higher levels in several other European countries. I invite you to compare these levels with those prevailing at the beginning of this century when the French economist, Paul Leroy-Beaulieu wrote that taxes above 12 percent of national income would be "exorbitant" and damaging to the growth prospects of countries. Leroy-Beaulieu was concerned about levels of taxation which, by today’s standards, would be considered as extremely low. He would probably react with incredulity to levels as high as 50 percent of GDP or even more. Surely, taxes at these levels must affect incentives and individuals’ decisions.

Which taxes have been most instrumental in supplying funds for the increasing appetites of large government budgets over the years? They were mostly personal income taxes, value-added taxes, and social security taxes. In a historical perspective, these are relatively recent taxes. Many policymakers and economists now believe that very high taxes must have distorting effects on a country’s saving rates, on the allocation of investment, on the entrepreneurship of the population, and on employment. Indeed a recent IMF staff analysis of this trend over the past 30 years noted that a particularly heavy share of the increase in the revenue burden has fallen on labor income, and less skilled, lower paid labor in particular. Such distortions may well act to slow down growth, employment generation, and the creation of new enterprises.

An unduly high level of social security taxes, according to many recent studies, are widely believed to contribute to high unemployment. These taxes raise the cost of labor andcreate a high "wedge" or gap between the cost of labor to the employers and the wages that workers receive. The incentives work against employment. Employers reduce their demand for labor and are tempted to replace workers with capital. At the same time, individuals are encouraged to choose economic activities that can more easily escape taxation, such as activities in the hidden economy.

But how can social security taxes be reduced when pension expenditures and structural unemployment are so high at present? For the future, as the populations of many industrial countries age, pension and health care costs are almost certain to rise. This is a dilemma that most industrial countries now face, one that will not go away. And it is not confined to the high public-expenditure countries of Western Europe. Japan and the U.S. with higher proportions of private coverage face similar challenges.

In addition to increasing taxes, many countries have, over the years, also borrowed to finance their high levels of spending when tax revenues were not sufficient. France is not among the countries that have relied most heavily on this type of financing. Even so, public debt has risen over the decades to almost 60 percent of GDP. In some countries, though, high spending has led to an accumulation of public debt to very high levels, in some, exceeding 100 percent of GDP. This was the reason why the Maastricht Treaty imposed debt limits as a condition for being part of the European Union. High debts divert tax resources toward their servicing and complicate the conduct of monetary policy.

Let me touch briefly on the other type of cost of the welfare state. Too briefly perhaps, for this is a complex and controversial area. Unemployment compensation and employment protection have been twin features of the European systems for decades; and for good reason. Now we find that unemployment levels have risen to historically very high levels and have become an almost intractable problem. Could it be that the welfare state is contributing to this? Unemployment benefits that replace a high proportion of previous earnings and that last for long periods must surely have a role in reducing the incentive to seek work. Employment protection legislation, high social security taxes, or excessively high minimum wages are all factors that can raise the costs of employment. Uncomfortable as it may be, the scourge of unemployment is unlikely to be removed unless these and other features of welfare systems are reviewed.

Another problem that has attracted wide attention in connection with welfare states is that, despite the best intentions of policymakers, existing programs have, in some countries, created a type of social segmentation. Two categories of citizens are found: those who are employed and are entitled to quite generous benefits if they lose their jobs; and those who are effectively excluded from the labor force and have few opportunities to re-enter the mainstream of society. The image springs to mind of a medieval city with its walls to protect the citizens inside them, but left totally unprotected those who were outside.

The insiders are those with jobs and access to the many benefits that come with holding these jobs. They can largely rely on good wages, job security, health benefits, assured pensions, and many other benefits which sometimes even include expenses-paid vacations. On the other hand, in many of these countries, unemployment rates have been very high and the unemployed share to a much lesser extent in the benefits of a welfare state. This is especially tragic for younger people for whom the unemployment rate has been extraordinarily high and who may become socially alienated.

III.Future Trends

In future years, two trends will provide increasingly difficult challenges for the present structure of the welfare state. To call them "trends" is too mild. They are irresistible forces, one domestic, one global. They are: demographic change and globalization. Let me say a few words on each of them.

Most industrial countries, and even some developing countries, especially in Asia, face the long-term fiscal challenge of an aging population. As standards of living and hygiene have risen, and major advances have been made in medicine and disease control so life expectancy has risen. In the industrial countries, at the beginning of the twentieth century, life expectancy was about 50. In just 100 years it has risen to about 70-75. Even higher in Japan. At the same time the tendency has been to lower retirement age and to expand retirement benefits. Simply stated: longer life costs more. The cost arises largely because the number of years in retirement increases with respect to the number of working years of the individual. But also, in the many countries that have large state-supported pension schemes on a non-contributory or pay-as-you-go basis, more pensioners must be supported by fewer workers. And those costs exist as a cost to society whether they are funded through the state or through private schemes. The recent title of a book put it well: "Can we afford to live longer?" Or perhaps more accurately, can our children and grandchildren afford for us to live longer?

But why should welfare states worry about globalization? In a word, competition. Globalization has seen the lowering of trade barriers around the world. Countries no longer find it so easy to hide behind protective barriers and so are less able to support levels of benefits for their work forces that are superior to those in competing countries. Unless of course, the differences are warranted by higher productivity.

Over the past decade, or perhaps slightly longer, the rapidly increasing international mobility of capital has reinforced this trend, making it attractive for multinational corporations to locate their operations where costs are lowest. Despite the current crisis in international capital flows, I anticipate that this trend will continue in the long term.

Globalization will make it increasingly difficult for countries to have tax levels that are substantially above those of the countries with which they compete. This "tax competition" is increasingly a reality that cannot be ignored by countries, a reality that will make it very difficult for countries to increase their tax burdens to the levels required by the anticipated expenditure trends in the next generation. It will even make it increasingly difficult to maintain the current tax levels because they are well above those of countries which are not welfare states. For example, in France and Italy, the level of taxation is now about 12–13 percentage points of GDP above that in the United States and Japan.

IV.Responding to the challenges

Does the above discussion mean that the welfare state should be dismantled and replaced by a role of government that is minimal and lets most citizens take care of themselves? In my view, the social gains that have been achieved by the welfare state and the social culture that has developed in European societies would not allow such a drastic change. Nor would I recommend it! Nor would I recommend that other countries around the world copy exactly the model of today’s welfare states.

First, the existing welfare states. Yes, reform is necessary. But reform does not need to mean revolution! Many reforms concern changes in the design of benefits, not changes in terms of social objectives. The IMF as well as several other organizations, such as the OECD, and the World Bank have, in recent years, identified many possible reforms that would permit the reduction in the cost of the welfare states without basically or fundamentally changing the role of government.

These are reforms that would reinforce rather than destroy the welfare state, preserving its role as a guarantor of certain basic or minimum standards. At the same time they would instil a sense of responsibility in the individual. Or to put it in coldly economic terms, the reforms would utilize incentives, thereby contributing to efficiency and, in the end, through higher output, resulting in a boost to individual and collective welfare.

Major reforms are possible in the areas of pensions, health, education, employment, infrastructure, public enterprises, and in many other areas in which governments now operate.

First, pensions. As I have said, many countries have adopted pay-as-you-go systems for funding pensions. With these systems, societies are committing future generations to much higher liabilities—and taxes to finance them—or reduced benefits. We have recently begun to refer to these liabilities as an "invisible debt." Pensions can be reformed in various ways:

by increasing the retirement age;

by reducing or eliminating the possibilities that often exist of taking early retirement without a commensurate reduction in pension benefit;

by reducing the size of the pension through less generous indexation mechanisms.

An even more positive type of reform would be to promote systems and incentives that encourage citizens to supplement the minimal level of pension that the state supplies, with individual saving related to privately run pension programs.

These reforms should be taken promptly. One piece of analysis within the IMF has looked at the cost of delaying such reform in a "typical" industrial country. This suggests that a 10-year delay in addressing pension reform would permanently increase the contribution rate to pensions by about 1 percent of GDP. A 30-year delay would raise it by 5 percent of GDP. What reforms would help? As an illustration, the same analysis notes that in France and Italy, the unfunded gaps could disappear if they were to raise their mandatory retirement age to 67, subject of course to many assumptions.

Second, in the areas of social services, health and education. Countries may increasingly have to explore options that shift some of the burden to individuals, or at least provide them with the opportunity to seek private provision of services. This is not a call for wholesale privatization.

For instance in health care, benefits can be reduced by introducing or increasing charges paid by the patients; by developing standards that discourage unnecessary surgery or too expensive technological developments; by using generic pharmaceuticals; and by modernizing hospital networks.

Educational expenditures can be reduced by introducing modern technology and teaching methods in schools and thus replacing some traditional direct teaching by staff, by shifting some expenses to the private sector, especially for higher levels of education, and so on.

Third, costs associated with unemployment can be reduced by making labor markets more flexible. A key issue in many industrial countries at present is the effect of employment protection legislation and minimum wage regulation that, as I noted earlier, raises the effective cost of hiring labor. These are highly sensitive issues, but the laws need to be kept under review, to ensure that they do not represent a distorting, counterproductive influence in labor markets and to make sure that those on benefits are given incentives to re-enter the work force.

Allow me some very brief reflections on what lessons may be drawn for France.

France confronts many of the issues I have mentioned today. It has a pension system that, despite some reforms in the early 1990s, remains one of the most generous in the industrial world. So too is its unemployment scheme. Health care costs have been rising strongly as in other countries. Moreover unemployment benefits, while they have been reformed, remain generous by international standards, and recipients need stronger incentives and opportunities to find a job or receive appropriate training to improve their skills. Recent analysis by our staff in the IMF suggests that the tax burden on today’s young people will, over their lifetimes, be more than half as large again as the tax burden on today’s middle-aged. A clear indication of the costs to future generations of the welfare state.

Going further, a subsequent analysis looking at the long-term effects of high entitlements and taxes pointed to major fiscal policy challenges in the years ahead. Revenue and expenditure rose to levels that would be unsustainable unless substantial adjustments were made to programs regularly. Indeed, the prospect is for the very prosperity of future generations to be undermined by the structure of benefits that prevails today.

The case for continued reform in many areas is very clear.

V.Implications for the rest of the world

For the rest of the world, many countries look to today’s welfare states for the lessons of experience, as they try to provide for their own populations. In the developing countries generally there is the continued challenge of tight resource constraints, poverty, and rapid population growth. The economies in transition face acute challenges in constructing safety nets for those affected by reform, while trying to introduce mechanisms compatible with the market to provide key services while raising adequate revenues. More recently we have been reminded of the very high social costs experienced by the Asian countries in economic crisis.

Most of these countries are quite different in terms of their demographic profiles: young populations are the norm. But in some higher income Asian countries, the phenomenon of the aging population is already present. And all are exposed to the forces of globalization.

In all these countries, it is fair to say that the social protection systems are far more rudimentary than those of the welfare states. The systems are in their infancy. What lessons can we distill from today’s welfare states for these other countries? I would highlight two keywords: equity and cost. All countries in designing their welfare systems must walk a precarious balance between these two often conflicting goals. I shall not belabor the point about cost; I have said enough already.

As to equity, the observations from a recent conference sponsored by the IMF on equity, provide some valuable principles that can be used by countries as they design their social policies:

Sound macroeconomic policies are essential for promoting equity and growth in the medium to long term. Equity does not hamper growth. It enhances it. Certainly equitable policies will reinforce public support for economic reform and adjustment.

Equity is a multidimensional concept that encompasses equitable distribution of opportunity, wealth, consumption, and availability of employment opportunities.

Priority should be concentrated on improving the prospects of the least fortunate in society. How? By improved access to education, health services, credit, and justice.

Social safety nets that are cost-effective and well-targeted are essential to shelter the most vulnerable during difficult times.

Equity is not a rigid concept; each society must decide through consultation with its citizens and civil institutions what level of equality is desirable.

And what of the IMF? I have not addressed our role directly today. Increasingly over the years, issues of social protection and equity have assumed increasing importance in our policy dialogue with governments. And in the programs we support with our finance, we have become insistent that governments include adequate provision for social safety nets, education, health, and other social services. Indeed, this lesson was reinforced by the recent external evaluation of our enhanced structural adjustment facility (ESAF) as a result of which we are committed to pressing the quality of fiscal adjustment. As I reflect on the five principles that I have just enumerated for governments, there is no better summary of the principles that should guide our thinking within the IMF on issues of social equity. At a more general level, I am proud that the staff of the IMF has been very active in thinking of ways to preserve the social achievements of years past while making economies more efficient and viable.

VI.Conclusion

If it is to survive, the welfare state in the industrial economies will need important reforms. These reforms will be necessary for it to co-exist with a domestic market economy and an increasingly globalized world open to prevalent tax competition. I would hope that the policymakers in the welfare states can learn from the large inventory of possible reforms. By making appropriate choices they will improve the running of their economies, by reducing unproductive spending and improving the quality of tax systems. Not only is this consistentwith their social goals; it is also more likely to be able to enable them to withstand the pressures of globalization.

As for the lower income emerging economies, which are the main beneficiaries of globalization, they face different pressures. The demands on them are to make their social support systems more comprehensive, mimicking perhaps the systems of the industrial world. As living standards rise, and social programs become more adequate, I anticipate that we will see a trend toward convergence in the standards of social protection that are seen in countries throughout the world.